A Non-Deliverable Forward (NDF) is a financial derivative contract used in foreign exchange (FX) markets, primarily for currencies that are not freely convertible or are subject to capital controls. Unlike standard forward contracts where the underlying currencies are physically exchanged at maturity, an NDF is settled in cash based on the difference between the agreed-upon forward rate (the NDF rate) and the prevailing spot rate at the contract's maturity date.

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Key features include:

• Cash Settlement: Only the net difference between the NDF rate and the spot rate at maturity is paid, typically in a freely tradable currency such as the U.S. dollar.
• No Physical Delivery: The actual currencies are not exchanged; instead, the settlement is done in cash.
• Use Case: Commonly used for hedging or speculating on currencies from emerging markets with trading restrictions, such as the Chinese yuan (CNY), Indian rupee (INR), or Brazilian real (BRL).
• Over-the-Counter (OTC): NDFs are traded privately between parties, not on formal exchanges.

The formula for settlement is:

Settlement Amount=(NDF Rate−Spot Rate)×Notional Amount

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If the result is positive, one party pays the other; if negative, the payment direction is reversed.

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Example:

Suppose a UK company sells goods to a business in Brazil and expects to receive payment in Brazilian real (BRL) in three months. However, the Brazilian real is not freely convertible outside Brazil, so the UK company cannot easily exchange BRL for British pounds (GBP) on the open international market.

To protect against a possible fall in the value of the real, the UK company enters into an NDF contract with a bank. They agree on a future exchange rate for BRL against GBP for the payment date.

When the contract matures, the market exchange rate (spot rate) for BRL/GBP is compared to the rate agreed in the NDF contract. If the real has weakened, the bank pays the UK company the difference in GBP. If the real has strengthened, the UK company pays the bank the difference, again in GBP.

In this example, Brazil (BRL) and the United Kingdom (GBP) are the countries involved, with settlement in a freely tradable currency (GBP in this case, though often USD is used).

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